Key considerations when making direct private investments in venture capital

I get this question a lot from friends who are considering making direct investments in startups. I also see this debate playing out in the public square. Having had the opportunity to invest in the private markets in the last 15+ years, my view is that direct investments by individuals are the the most risky type of allocation one can make UNLESS capital, deal flow, expertise, diversification, and management exist and align.

Below is my list of pre-conditions for individuals when they consider making direct investments in early-stage startups:

  1. Significant capital is available for investments.
  2. Have deal flow to be able to "pick and choose" what to invest in. In general, 1000 opportunities in the deal flow yields 2-3 high-conviction investments, per partner/principal investor. For the group of "high potential investments," in the funnel, a clear, rigorous, and sophisticated due diligence process needs to be put in place to evaluate the risks and upsides.
  3. Deep domain expertise and know-how to evaluate opportunities in the deal flow.
  4. Deep understanding of the capital formation and liquidation process to negotiate the right transactions. If the individual has not seen or invested in many deals, the individual does not know well "what is market" in terms of investment structures and terms. Furthermore, the capitalization of a company is generally not easy to manage given an existing capital stack and anticipated capital stack. Contrary to popular belief, individual investors have little influence on the capital formation process unless the individual has significant minority stake in the company, which is rare. Direct investments do not equate to direct influence in companies.
  5. Post-investment management and governance. Unlike public equities where the investment style is passive, private equities have active investment styles. The earlier the stage of the investment, the more active the investment style is because these companies need a lot of help shaping and molding into the next big company (this is the key reason that the higher management fees are charged by venture capital funds although there is a healthy debate regarding fund size, fees, and incentives). The post-investment management and governance, along with the quality of the initial investment, is a big contributor to the long-term success of private investments. Constant and consistent alignment with management teams and a deep understanding of the business are key to long-term success. This takes a lot of work, energy, thoughtfulness, and expertise. Most individual investors do not have the bandwidth to perform the necessary post-investment management. To build this bandwidth, they have to hire an experienced manager and a team.
  6. Diversification. A core tenant in financial investments. The diversification in private asset class is as important as diversification in public assets. In my view, the diversification in venture capital is balancing exposure to markets opportunities, market readiness, products, people, and capital. Individual direct investment or even multiple direct investments do not necessarily offer the right diversification or pooling of risks.

My writing reflects my own opinions and is not investment advice.

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